Why the bond market is more fragile than you think
Oct. 01, 2014
NEW YORK (AP) — A bottleneck is building in the global market for bonds.
Main Street investors have poured a trillion dollars into bonds since the financial crisis, and helped send prices soaring. As fund managers and regulators fret about an inevitable sell-off, the bigger fear is that when people go to unload, there won't be anyone to buy.
Too many funds own the same bonds, making them difficult to sell if panic ensues. On top of that, the banks that used to bring bond buyers and sellers together have pulled back from the role. If investors started looking to sell, they'd be slow to find buyers, spreading fear through the $100 trillion global bond market and sending prices tumbling.
It's a situation known as "liquidity risk" and some bond pros are scrambling to prepare for it.
Worried portfolio managers are hoarding cash. BlackRock, the world's largest fund manager, is suggesting regulators consider new fees for investors pulling out of funds. Apollo Management, famous for profiting from a bond collapse 25 years ago, is launching a fund to bet against bonds.
What's at risk is more than money in retirement accounts. Big investors often borrow when buying bonds and so losses can be magnified. Trillions of dollars of bets using derivatives ride on bonds, too. A small fall in prices could lead to losses that reverberate throughout the financial system.
"There's no place to hide," says JPMorgan's William Eigen, head of the Strategic Income Opportunities fund, who has 63 percent of his portfolio in cash.
Here are the reasons bond experts are worried:
HIGH PRICES: Demand and prices have soared for nearly every kind of bond, even the diciest. Since the start of 2009, funds invested in "junk" bonds from risky companies have returned an average 14 percent each year, double its average in the prior six years.
RISE OF QUICK-HIT INVESTORS: The biggest owners in many bonds are small Main Street investors more easily spooked than traditional holders like insurers and pension funds. Main Street investors buying through mutual funds and exchange traded funds, vehicles for quick-trading, own 40 percent of corporate bonds, according to the International Monetary Fund. The insurers and pension funds that help stabilize the market by sticking with bonds through busts hold 25 percent.
RATE HIKES: This market faces a big test next year when the Federal Reserve is expected to start raising interest rates. When the Fed announced a series of surprise rate hikes in 1994, bond prices plunged, a big hedge fund collapsed, companies like Procter & Gamble were hit with losses and Orange County, California, had to file for bankruptcy.
Many people don't think the rate increases next year will roil the bond market much because the Fed is telegraphing its every move. But given the high prices and lack of liquidity, not everyone is confident.
"The market isn't pricing in the risk that it's going to be like 1994 — or even worse," says Hans Mikkelsen, global credit strategist at Bank of America Merrill Lynch. His worries were echoed recently in an IMF report warning that a breakdown in trading could lead to "fire sales" in some parts of the bond market.
TRADING PROBLEM: To buy or sell many kinds of bonds, you have to phone or email brokers at banks and other firms who pair buyers and sellers. If they can't find a match for you, they dip into their own stash of bonds to buy and sell themselves.
But banks and other middlemen are pulling back from this matchmaking because of new regulations limiting their activities. And they have largely abandoned their role as a buyer or seller of last resort. They've slashed their stash of bonds by 80 percent since 2007, according to State Street Global Advisors.
The result is a shallow market in which buyers and sellers struggle to find each other, and prices can fall fast.
After the Federal Reserve hinted at a pullback from its bond-buying program last year, bonds from the safest "investment grade" companies fell 6.2 percent in less than two months, according to Barclays Capital.
Bonds bounced back when the Fed delayed its withdrawal of stimulus, but it spooked fund managers. They responded by raising cash from 6.3 percent before last year's sell off in May to 9 percent a year later, according to the Investment Company Institute.
That extra cash helped when junk bonds fell recently. Fearing the Fed might raise rates faster than expected, investors pulled billions of dollars out of junk bond funds earlier this summer. Many fund managers were able to the pay the investors without causing a panic. By the end of the month, the funds had fallen an average of 1.2 percent, according to Morningstar.
"Everyone thought it would be a blood bath," says Marilyn Cohen, founder of Envision Capital, a bond manager. The story is "crisis averted, for now."
But Michael Lewitt of the Credit Strategist Group is warning investors not to fool themselves that the worst in over. "When there's little liquidity, it doesn't take many sales to move the price," he says.
You can reach Bernard Condon on Twitter at http://twitter.com/BernardFCondon.